Friday, November 30, 2012

Here is his Charles Goode Oration at the Melbourne Business School Thursday night:

Tonight I want to ponder on a few thoughts that came to me in my previous
occupation, and have developed further in my more recent work in the
investment community.

Specifically, I hope to answer two questions and make one historical
observation. The questions are:

• Do our media concentrate too much on short-term economic news,
and do they do so more than in other countries?

• Does it make us happier and better able to do our jobs and invest our
savings?

• And finally I want to make an observation abou some really important
long run price developments and their implications for Australia.

(1) Do we get too much economic news?

People with jobs like I had have always been at the receiving end of a lot of
economic information, most often from official sources like the Australian Bureau
of Statistics, but increasingly now from private providers of survey information.
Over the past couple of decades the general public has also been inundated with
this type of information.

The newspapers and magazines are full of economic news, as is radio and
television, where there are special programs devoted to it. This is a world-wide
phenomenon, and you can turn on a television set in a hotel in the US, Europe or
Asia and hear someone holding forth on the latest movement in exchange rates,
share prices or bond yields at any time of day or night.

While it is a world-wide phenomenon, it is more pronounced in newspaper
coverage in Australia than elsewhere. I have often heard foreign visitors or new
arrivals express surprise at how much economic coverage there is in Australian
papers, particularly on the front page.

We did a comparison at the Reserve Bank a few years ago of how much coverage
was given to a particular piece of economic news, namely central bank monetary
policy decisions. We looked at it in Australia and the UK and the US (the latter two
being the financial capitals of the world). We took three comparable newspapers
in each country; in the UK, the Financial Times, the Times and the Independent:
in the US, the Wall Street Journal, the New York Times and the Washington Post;
and in Australia, the Financial Review, the Australian and the Sydney Morning
Herald (The Age would have been similar).

We added up the number of articles in these papers in the three days surrounding
two successive monthly monetary policy meetings. Our findings were as follows...In the US, 35 articles;

In the UK, 46 articles;

In Australia, 131 articles.

Then we looked at how many of these articles were on the front page. The
results;

In the US, 1 article

In the UK, 1 article

In Australia, 14 articles.

Why is there so much more coverage in Australia than elsewhere?

One explanation I have heard is that there is not as much other news to report.
We are not an international power or trouble spot, we are not engaged in major
wars, we do not have racial riots, civil insurrections, or sectarian violence, and
the private lives of our politicians are not as lurid as British one (or a recent
American president). So instead our newspapers are taken up with recent figures
on employment, interest rates, the CPI or the Budget.

With the media competing so strongly against each other, there is inevitably
a bias towards sensationalism. While Australia has a few experienced and
thoughtful economic commentators who are world class, it also has a multitude
of eager beavers who are mainly concerned with tomorrow’s headlines. They
try to extract the maximum amount of coverage out of each ephemeral piece of
news – monthly or even daily figures are invested with a significance well beyond
their actual information content.

Interest rates do not merely rise, they ”soar”, the exchange rate “dives”
or “plunges”, Budgets “blow-out”. The reader is left with the impression of
constant action and turmoil. The recurring television image is of people in dealing
rooms or on the floors of futures exchanges shouting at each other.

Another feature is the tendency to concentrate on pessimistic news. It is the
nature of all journalism – not just economic – that its practitioners seek to expose
a disaster or a conspiracy. No one ever wins a prize in journalism by pointing
out that things are proceeding relatively smoothly and uneventfully, hence the
tendency to find bad news, mistakes in policy and to label every minor glitch as a
crisis (the most over-worked word in journalism).

At the margin I believe all this news tends to make us less confident, less secure
and less happy than if we had less of it.

(2) Does all this economic news make us better at doing our jobs or investing
our savings?

The normal first response would be to say of course it must. More information
must be better than less, that is what the whole information revolution is about.
It is hard to argue with this point of view in terms of most of the decisions we
make in everyday life. Certainly a broad range of information is better than a
narrower one. But is more frequent information about a particular economic
variable better than less frequent information?

Is it possible that if we are inundated with more information than we need, we
may not be able, as the old saying goes, to see the wood for the trees? Or another
way of saying this is that we may be on top of the detail but lose perspective, or
as T.S.Eliot said rather more eloquently:

. “Where is the life we have lost in living?

. Where is the wisdom we have lost in knowledge?

. Where is the knowledge we have lost in information?

I am not sure what the first line means, but the latter two are pretty clear.

Another way of expressing this thought is given by Nate Silver in his recent
book – “The Signal and the Noise” where he warns “We face danger whenever
information growth outpaces our understanding of how to process it”

Another reason we should question the value of frequent information is that
it is subject to a distortion known as the “narrative fallacy”. This is the need to
be able to tell a story as to why a movement in an economic variable occurred,
even if it is a very short-term movement. Every day the exchange rate changes,
so does the share price index, and every day you will be told why they changed,
i.e. what caused them to rise or fall even if they only moved by a few tenths of
one percent. Do we really know the reasons behind these small daily moves, or
do we just make up a story because we can’t bear to say that we don’t know why
they moved? It is often just random noise, but we can’t say that. Similarly, each
movement in a monthly statistic such as retail sales, employment or business
confidence has to be explained by some other economic or political development,
although in many cases the movement is just due to sampling error. Incidentally,
not only do we think we can explain past events that we can’t, but we also think
we can forecast future ones that we can’t, but that is another story for another
day.

I want to now turn to the question of whether more frequent information
enables us to become better decision makers, in particular whether it makes
us better or worse investors. Let me start by mentioning that several financial
advisors I worked with told me that, among their clients who run self-managed
super funds, those that spent the most time tracking daily movements in their
portfolio achieved worse investment results than those who reviewed theirs’ less
frequently. This is, of course, only hearsay, but it sounded plausible to me for
several reasons. Let me elaborate.

It has been established from a lot of experimental research that most investors
exhibit “loss aversion” That is they experience more unhappiness from losing
$100 than they gain in happiness from acquiring $100 (approximately twice as
much according to the evidence). So the more often they are made aware of a
loss the more unhappy they become.

If the stock market rises by 6 per cent per annum, that, plus dividends is a
reasonable return and should not be a cause of unhappiness. But given the
variability of daily movements, on average about 47 per cent of days the
market would fall, and on 53 per cent it would rise. Since we experience more
unhappiness from the falls than happiness from the rises, this daily flow of
information would result in a net fall in happiness. If we reviewed the market
on a monthly basis, there would be a smaller proportion of losses, and a larger
proportion of gains, so we would be happier. What this shows is that more
frequent information makes us less happy, but it does not necessarily mean we
become worse investors.

However there is a body of research in behavioural finance conducted by
experimental psychologists that shows that it also makes us worse investors.
This is because we tend to suffer from myopia (reading too much into short-
term movements) and loss aversion (already described). This research concluded
that ”investors who got the most frequent feedback (and thus the most
information) took the least risk and thus earned the least money.” This is very
serious research. Economists usually don’t like being lectured to by psychologists,
but the two who conducted this research – Kahneman and Tversky were the only
two non-economists ever to win the Nobel Prize in Economics (unfortunately
the latter died before he could receive it). These experiments are done with real
people and real money, and I will give a brief summary of how they worked.

In the experiment the subjects are able to invest in two asset classes – one, which
we may call equities, which has a higher average return, but more short-term
variability, and one, which we may call bonds, which has lower return and lower
variability. The investors in the experiment who receive daily information avoid
short term losses by buying more bonds and less equities than those who receive
monthly or quarterly information, and so as a result earn a lower return over the
long run.

A similar finding results even if the subjects are confined to investing in equities.
Those who receive daily information are inclined to act on it and over- trade. The
resulting increase in transaction costs lowers their return relative to those who
receive less frequent information.

So I think we can conclude that too much information, or more correctly, too
frequent receipt of economic and financial information, reduces the recipients
happiness and leads them to make inferior investment decisions.

(3) What of the Long-run?

I would now like to shift away from the problems of the short-run to look at some
really long run changes – changes that take decades, generations or centuries.
This is mainly of historical interest as it is probably impossible for an investor to
make money out of such changes.

Have you ever wondered how it was possible a century ago for so many
magnificent homesteads to be built in rural Australia (the National Trust has
produced several excellent books on the subject). Why were some farmers a
century ago able to build these mansions? The answer is that the price of wool
was so high that the owner of a large sheep station could afford to build a
mansion and to staff it with servants.

It turns out that changes in the prices of what we produce can explain a lot about
how economies and countries evolve. The example I gave above is a relatively
small one; there are other much bigger ones that almost defy comprehension.

• In 1667, under the Treaty of Breda, the Dutch government gave up
their claim on Manhattan to the English in order to retain the island of
Run (how many people know where that is – it is in Indonesia). Why
did they prefer the island of Run? Because it was the world’s main
source of nutmeg, which was highly-prized in Europe and extremely
expensive. (I wonder how many of you have consumed nutmeg in the
last week – you can buy a thirty gram jar of it at Woolies for $2.50).

• In the late eighteenth century, France had only enough armed forces
to protect one of its two major possessions in the Americas. It had to
choose between Canada and Haiti. It chose Haiti. Why? Because the
price of sugar was so high that more wealth could be extracted from
Haiti than the whole of Canada.

What is the significance of this sort of long run development for Australia? We
touched on it before when we observed the magnificent rural homesteads of the
late nineteenth century. Unfortunately that type of wealth did not last because
the real price of wool fell (like the real price of sugar and nutmeg).

From about 1900, the trend of prices for what we exported – mainly agricultural
and mineral products either fell, or at least did not rise as fast as the prices of
the goods we imported – mainly manufactures. This was because the supply of
agricultural and mineral products could easily be expanded by bringing new areas
on stream or by raising productivity. In economic parlance, Australia experienced
a trend fall in its terms of trade, and this made the country less wealthy than it
otherwise would have been.

Now as we all know from our daily papers, that has all changed. The terms of
trade have risen to an all time high, the mining sector is booming and agriculture
is looking up. Is this just a cyclical event, or has something more fundamental
changed that means it is more permanent. A famous investor said the four most
dangerous words in investing are “it’s different this time”. Is he right and should
we expect to return to the old pattern, or is it different now?

Well I think it really is different now. The long decline in the terms of trade ended
in about 1985, and a hesitant upward trend commenced. Then, over the past
half dozen years, notwithstanding the financial crisis, the terms of trade have
gone through the roof. Why has the downward trend of eighty years been so
comprehensively reversed? Essentially it is because of the emergence of the
developing countries as a major economic force. First it was Taiwan, Korea, Hong
Kong and Singapore, then Malaysia, Thailand and Indonesia. And finally the big
one – China, followed by India. Now it is the price of manufactured goods which
are falling as it is easy to expand their supply by bringing into production the
massive rural populations of China and India. This simultaneously provides us with
cheap manufactured goods to buy, and increases the demand for our exports as
inputs into their manufacturing processes.

Of course, it could all fall apart, but I don’t think that is likely. It is relatively easy
for countries to keep growth going when starting from a low base and being able
to adopt technology that has already been invented by others. Besides a world
where China and India play a major role is not really new: it is a return to earlier
times. Until the industrial revolution in the late 1700s, China and India accounted
for most of the worlds GDP, and their incomes per head were similar to those in

Europe. Looking back in a hundred years’ time, we may view the 1800s and the
1900s as an aberration when some countries with relatively small populations in
Europe and North America outpaced their larger rivals for a time.

I want to conclude now by asking where does all this leave Australia? In a very
favourable position I would say. It doesn’t mean that we won’t see some future
falls in export prices – that is already occurring – but on average they should
still remain high by historical standards. It also doesn’t mean that the current
expansion will continue indefinitely – the business cycle will re-assert itself at
some point. But, by the standards of other developed countries, we will remain in
a favourable position.

Just as all the short term economic data I talked about earlier reduced our
happiness and confused us as investors, this long term change in the world’s
centre of gravity should be a source of satisfaction to us. It has opened up many
opportunities already, and will open up many more in future years. That is why
I have been more optimistic than most observers despite the still remaining
damage caused by the 2008 financial crisis.